| ||Section 174 R&E Deduction Upon Statutory Stock Option Exercise|
J. Anthony Coughlan*
*The writer is a senior manager with the US Tax Consulting Group of PricewaterhouseCoopers Ltd. of Hong Kong and a member of the tax section of the Virginia Bar. Virginia Polytechnic Institute & State University, B.S., 1988; University of Virginia, J.D., 1992; Georgetown University Law Center, LL.M., with distinction, 1998. The writer expresses his gratitude to F. Howard Braithwaite, Elizabeth A. Chorvat, James E. Connor, Elizabeth N. Coughlan, John W. Coughlan, Edwin P. Geils, Robert Gold, Daniel I. Halperin, Sean B. Johnson, Bruce Larsen, Gregory A. Lee, James Marshall, Philip A. McCarty, Maria D. Murphy, Wayne Robinson, Christopher D. Scott, James R. Shanahan, Meg Y. Wang, and Christopher D. Wood for their advice and encouragement. The views expressed in the Article are those of the author and do not necessarily reflect those of PricewaterhouseCoopers or of anyone else. The writer dedicates this Article to his sons Elijah, Graham, Nathanael, and Walter. S.D.G.
Employee stock options, in large measure, have fueled the high-technology boom of recent years. Cash-strapped high-tech startup firms make up for the low salaries they offer with grants of stock options. Such firms face a choice: They can award nonstatutory stock options, or they can award statutory options. There are pros and cons to each type of option. Upon exercise, nonstatutory stock options are taxable to the employee and may be deducted by the employer under section 162. In contrast, statutory options upon exercise are not taxable to the employee and may not be deducted by the employer under section 162. These pros and cons of each type of option may balance each other out, and which type of option to award may therefore be of little importance for many profitable companies.
Yet for many high-tech startup companies, not having a section 162 deduction upon the exercise of a statutory option is not so bad: Because they are startups, they very well might not realize a profit anyway. If they do not realize a profit, then they do not have taxable income. And if they do not have taxable income, then they do not need an additional deduction. That is, because the company might never be able to utilize the good tax attributes of a nonstatutory stock option (the deduction), there does not seem to be much reason to saddle their employees with the bad tax consequences (taxable income upon exercise of the option). For this reason, the startup firm often would prefer to grant statutory options.
Of course, the hope, and the reality sometimes, is that the high-tech company eventually will have taxable income, and therefore such company naturally would like to have as many deductions as possible. Unfortunately, however, it is foregoing the possibility of claiming a deduction with its grant of statutory options. Or is it? The employer cannot claim a section 162 deduction for the exercise of statutory options, but can it claim other deductions under other Code sections in relation to the options? Specifically, may such a company claim a deduction under section 174 to the extent that the statutory options are awarded to employees engaged in research and experimentation?Section 421 generally controls the tax treatment of statutory options, which today are incentive stock options (ISOs) and options received pursuant to an employee stock purchase plan (ESPP). Section 421(a)(2) provides, in relevant part:
If a share of stock is transferred to an individual in a transfer in respect of which the requirements of section 422(a) or 423(a) are met…no deduction under section 162 (relating to trade or business expenses) shall be allowable at any time to the employer corporation…with respect to the share so transferred.
While section 421(a)(2) obviously disallows a deduction under section 162, it does not, explicitly anyway, disallow a deduction under section 174. So, provided the criteria of section 174 are met, is a deduction under section 174 allowed to the employer corporation with respect to shares of stock transferred to its employees in a transfer that meets the requirements of section 422(a) or 423(a)? That is, if ISOs or ESPP options are granted to an employee for performing research or experimentation, will the employer be allowed a section 174 deduction upon their exercise?
While this is a difficult question, this Article analyzes whether a section 174 deduction is allowable upon the exercise of statutory options granted for research or experimentation, and concludes that it is. This conclusion is by no means obvious; to the best of this writer’s knowledge, there is no reported case, authority, or other guidance concerning even an attempt to claim a section 174 deduction for the grant or exercise of a statutory option. That is especially significant in light of the fact that statutory options have existed since 1950, and section 174 since 1954. Apparently, no one has ever attempted to claim such a deduction in a half-century of that possibility existing, or, at least, there is no report of the Service ever challenging such an attempt. Apparently the language of section 421(a)(2), which disallows a section 162 deduction, has been interpreted—mistakenly, I submit—to disallow all deductions, not just section 162 deductions.
This Article examines, from a number of different perspectives, the proposition that a section 174 deduction can be claimed upon the exercise of a statutory option. Part II considers how the plain language of the statute supports the proposition, but questions whether such plain meaning is absurd or ambiguous. Part III explores whether allowing the deduction would violate any matching principle requiring that an employer may not claim a deduction until the employee includes the item in income. Part IV discusses what light extrinsic sources may shed on the question. Part V takes a step back and views section 174 in the context of nonstatutory stock options—after all, if a section 174 deduction is not allowed in that context, it might appear unlikely that one would be allowed in the statutory option context. Part VI covers to what extent other areas of the tax law treat the statutory option spread as a compensatory expense. Part VII concludes with some possible implications of deductibility of a statutory option exercise under section 174.